No one adopts a child “for the money.” To the contrary, most see adopting as an act of giving. A rare act of fiscal atonement recently occurred when Congress changed the Adoption Tax Credit to give back to those who so generously give of themselves. These changes are unprecedented and make a large number of adoptive families eligible for substantial tax refunds. How substantial? Extraordinary – the largest individual credit ever administered by the IRS. At HBS Tax it is not uncommon for us to help qualifying families claim refunds of $30-$40-even $50,000.
The adoption credit was designed to reimburse adoptive parents for qualified adoption expenses and provide tax relief to adoptees of “special needs” children (discussed below). Prior to 2010, the credit was nonrefundable – meaning it would reduce tax liability but would not generate a refund. Although any unused credit could be carried forward, it was lost if not used within five years. Because the credit was not refundable many adoptive parents saw little benefit and did not claim the credit or carry it forward. Recent changes, however, have made it worthwhile to amend these past-year returns to claim the credit in 2010.
The Changes: Effective January 1, 2010, the adoption credit was increased to $13,170 and made refundable. Adoptive parents can now receive the credit even if they owe no income tax. This refund-ability also applies to any credit carried over to 2010 from a previous tax year. The credit will also remain refundable for adoptions occurring in 2011.
Qualifying Children: To qualify for the credit/exclusion, the adoptive child must be an “Eligible Child” or a “Special Needs Child”. An “eligible child” is either under the age of 18 or a person physically or mentally unable to take care of his or herself. A “special needs child” is defined as an eligible child who meets three additional criteria: (1) Be a citizen or a resident of the United States or U.S. possession. (2) A state agency must determine that the child should not or cannot be returned to their parent’s home. (3) The state must also determine that a specific factor (such as the child’s age, ethnic background, medical condition or handicap) makes adoption unlikely without assistance. The primary difference between adopting an eligible child or a special needs child (as it pertains to the adoption credit/exclusion) is that the credit for an “eligible child” is limited to qualified expenses actually spent on the adoption. The credit for adopting a “special needs child,” on the other hand, is the full credit amount ($13,170 in 2010) regardless of the amount actually spent.
Qualified Expenses: Qualified adoption expenses include adoption fees, attorney fees, travel expenses and re-adoption fees for a foreign child. They do not include expenses paid or reimbursed by government programs, costs associated with surrogate parenting, or the cost of step-parent adoptions. If the adoption is a “foreign adoption” the credit/exclusion is only allowed if the adoption becomes final. If the child is a U.S. citizen or resident, the credit is allowed whether or not the adoption is successful. The credit/exclusion limit is a per-child/adoption limit, not an annual limit.
Those who claim the credit should be prepared to wait for their refunds for a number of months. They should also amend any prior-year returns related to the credit prior to filing their current year return. The IRS was apparently blindsided by the number of families who qualify for the credit as well as the size of the refunds being claimed. As a result, every return claiming the credit is subject to special audit procedures.
In this article, I have discussed some major changes to the adoption credit. I have not discussed many of the credit’s complexities such as limits on filing status and income limitations of those claiming the credit or the impact of employer adoption assistance. As always, do not rely on this information as a basis to make any financial decisions. Feel free to contact our office to consult with a tax professional.
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